Albon, Mykaella Joy N.

Managerial Economics
BSA 1-9 Assignment

PROFIT MAXIMIZATION

 An assumption in classical economics is that firms seek to maximize profits.

 Profit = Total Revenue (TR) – Total Costs (TC). Therefore, profit maximization occurs at the biggest
gap between total revenue and total costs.
 A firm can maximize profits if it produces at an output where marginal revenue (MR) = marginal cost
(MC)

Diagram of Profit Maximization

To understand this principle look at the above

diagram.

 If the firm produces less than Q1, MR is greater

than MC. Therefore, for this extra output, the firm is
gaining more revenue than it is paying in costs, and
total profit will increase.
 Close to Q1, MR is only just greater than MC;
therefore, there is only a small increase in profit, but
profit is still rising.
 However, after Q1, the marginal cost of the
output is greater than the marginal revenue. This
means the firm will see a fall in its profit level because
the cost of these extra units is greater than revenue.

Profit maximization for a monopoly

 In this diagram, the monopoly maximizes

profit where MR=MC – at Qm. This enables the
firm to make supernormal profits (green area).
Note, the firm could produce more and still
make normal profit. But, to maximize profit, it
involves setting a higher price and lower
quantity than a competitive market.
 Note, the firm could produce more and still
make a normal profit. But, to maximize profit, it
involves setting a higher price and lower
quantity than a competitive market.
 Therefore, in a monopoly profit maximization
involves selling a lower quantity and at a higher
price.
 Profit Maximization in Perfect Competition

 In perfect competition, the same rule for profit maximization still applies. The firm maximizes
profit where MR=MC (at Q1).
For a firm in perfect competition, demand is perfectly elastic, therefore MR=AR=D.
 This gives a firm normal profit because at Q1 AR=AC.

Profit Maximization in the Real World

Limitations of Profit Maximization

 In the real world, it is not so easy to know exactly your marginal revenue and the marginal cost of
last goods sold. For example, it is difficult for firms to know the price elasticity of demand for their
good – which determines the MR.
 It also depends on how other firms react. If they increase the price, and other firms follow, demand
may be inelastic. But, if they are the only firm to increase the price, demand will be elastic (see: kinked
demand curve and game theory.
 However, firms can make a best estimation. Many firms may have to seek profit maximization
through trial and error. e.g. if they see increasing price leads to a smaller % fall in demand they will
try increase price as much as they can before demand becomes elastic
 It is difficult to isolate the effect of changing the price on demand. Demand may change due to many
other factors apart from price.
 Firms may also have other objectives and considerations. For example, increasing price to maximize
profits in the short run could encourage more firms to enter the market; therefore, firms may decide
to make less than maximum profits and pursue a higher market share.
 Firms may also have other social objectives such as running the firm like a cooperative – to maximize
the welfare of stakeholders (consumers, workers, suppliers) and not just profit of owners.
 Profit satisficing. This occurs when there is separation of ownership and control and where managers
do enough to keep owners happy but then maximize other objectives such as enjoying work.
 COST MINIMIZATION

Profit Maximization and Cost Minimization

Remember that the firm's problem is maximizing profits by choosing the optimal quantities of inputs
to employ and output to produce. We already know how to solve the firm's profit maximization
problem in a competitive market environment. This direct approach is great but there are some very
important insights especially on the cost side of the firm's problem that can be gained if we look
at the firm's problem through a more indirect approach. The idea is to break down the profit
maximization problem of the firm into two stages: first, we look at the problem of minimizing costs
of producing any given amount of output, and second, we look at how to choose the most profitable
output level.
These notes cover the first of these two stages, i.e. they answer the question: for a given
amount of output, 𝑦 (just some number, 10, 20, 100, which does not have to be necessarily the firm's
optimal output that it will end up producing) what is the minimum cost of producing it. In other
words, we ask given that we have to produce 𝑦 units of output and given input prices 𝑤1 and
𝑤2 , how much of each input should the firm employ to produce 𝑦 in the least costly way.
Notice that the amount of each input that will be used will depend on the output level that the firm
wants to produce - if you want to produce 1000 units of outputs you would definitely need more
workers and machines than to produce just 10 units.
Notice that cost minimization is a necessary condition for profit maximization in competitive
markets. If, for a given level of output, one is not cost minimizing that means that he is also not profit
maximizing. Why? For a given 𝑦 revenue is fixed (taking 𝑝 as given), so if there is a less costly way
to produce this output level this will lead to higher profits.
The Cost Minimization Problem
Given the above discussion the firm wants to solve:
How is it interpreted? The firm wants to minimize its costs (𝑤1 𝑥1 +
𝑤2 𝑥2 ) of producing 𝑦 units of output. The fact that the firm wants produce
𝑦 units of output is given by the constrain f(x1; x2) = y: Remember that the
production function, f(x1; x2)corresponds to the maximum output that can be extracted from x1
units of input 1 and x2 units of input 2 - i.e. (since inputs are costly), using the production
function we would use x1 and x2 most efficiently. The cost minimization is then done by
choosing how much of each input to employ (x1 and x2) such that the costs of producing y
using the production function are minimized.
How Do We Solve The Cost Minimization Problem?
In general the cost minimization problem is harder to solve that the consumer problem or the profit
maximization problem since usually the constraint (f(x1; x2) = y) is a non-linear function of x1
and x2 so sometimes it may be hard to express x2 in terms of x1 from it and plug into the costs that
we are minimizing. When this is the case there are two ways to proceed of which the first is simpler
and recommended and the second is optional for those of you with more knowledge of math
(you can use either one at the exams):
 𝑤1
1. Solving the cost minimization problem using the optimality condition 𝑇𝑅𝑆 = 𝑤2

Remember that we showed in class graphically that at the optimal choice of input quantities (the
optimum) we must have that the isocost line is tangent to the isoquant corresponding to output level
y: The slope of the isoquant is given by the technical rate of substitution (TRS) which is a function of
x1 and x2: Why? Because remember what the TRS is equal to: it equals minus the ratio of marginal
𝑀𝑃1 (𝑥1 ,𝑥2 )
products, i.e. 𝑇𝑅𝑆 = − 𝑀𝑃2 (𝑥1 ,𝑥2 )
but the marginal products are functions of x1 and x2 since they are
simply the partial derivatives of the production function which is a function of x1 and x2: The slope
of the isocost line (remember from class) was w1 i.e. minus the ratio of the input prices (this is
similar to the slope of the budget line, however note that the isocost curve does not serve the same
purpose as the budget line). In the consumer problem we had a fixed budget line and we were trying
to and the point on this budget line which would give us maximum utility - i.e. the point which lies
on the highest indifference curve. In contrast, in the firm's problem we have a fixed isoquant and we
are trying to find the point on this fixed isoquant which gives us minimum costs, i.e. the point
lying on the lowest isocost line.
Given the above, we can solve the cost minimization problem by solving two equations for the
two unknowns x1 and x2: the optimality condition and the constraint that y must be produced:

Notice that y is not an unknown! It is just a fixed level of output we want to produce (say 10, 20, 0
or whatever). We do not have to solve for y - it is given. The solutions to the above problem
and will be generally functions of everything that is given: the input prices, w1 and w2 and the
output level y; i.e. we will have:

These solutions (to the cost minimization problem of a firm facing input prices w1 and w2
which wants to produce y) are called the conditional input demands for producing y units of
output at input rises w1 and w2: Why are they called conditional? Because they are conditioned (i.e.
depend on) what level of output we want to produce - if we want to produce more output more inputs
will be needed in general.
Difference between the conditional input demands from the cost minimization problem and the
(unconditional) input demands from the profit maximization problem
It is important to understand that the conditional input demands coming from the cost
minimization problem above are not the same thing as the (unconditional, as sometimes called)
input demands resulting from the profit maximization problem (see the notes on profitt
maximization and input demands). Remember the profit maximizing input demands,
and were functions of the input prices, w1 and w2 and the
output price p: They are called unconditional (or simply not called conditional) because they do not
depend on y - the output level in the firm's pro t maximization problem is already optimized and this
optimized output level is a function of the prices (w1; w2; p) that are taken as given by the rm - thus
the (unconditional) input demands are only functions of what is given, i.e. the prices. In contrast, the
cost minimization problem is being solved for a given output level which is not necessarily the
optimized one that the firm will eventually choose. Why? Remember the cost minimization problem
was only the first step in the indirect approach to solve the firm's problem and at that first step the
output level was taken as given as we were only interested in how to produce any given output level
at minimum cost. Thus the conditional input demands depend only on what is given in the cost
minimization problem - i.e. the input prices, w1 and w2 and the output level y: One more time: the
(unconditional) input demands depend on output price, p, the conditional input demands depend on
output level, y: Both of them depend on input prices, w1 and w2:
2. Solving the cost minimization problem using the Lagrange method
For those of you interested in math and knowing what the Lagrange method of solving
optimization problems is, the cost minimization problem of the firm stated above can be solved also
using this method. What we do is write the Lagrangean:

Where is the Lagrange multiplier on the constraint. Then we have to take the partial derivatives
of the Lagrangean with respect to its three arguments, x1; x2 and and set them equal to zero:

where and are the first partial derivatives of the production function
with respect to x1 and x2: The last equation is simply our constraint. We can take the first two
equations above to get:

Divide them through (both sides) to get:

But what are the partial derivatives of the production - remember they are simply the marginal
products of each input, MP1(x1; x2) and MP2(x1; x2): Thus we get:

which is what we had before! Then this equation, together with the constraint 𝑓(𝑥1 ; 𝑥2 ) = 𝑦
can be used to solve for the conditional input demands and .
 PRINCIPLES OF DERIVATIVES
Derivative by First Principle

Derivative by first principle refers to using algebra to find a general expression for the slope
of a curve. It is also known as the delta method. The derivative is a measure of the instantaneous
rate of change, which is equal to

This expression is the foundation for the rest of differential calculus: every rule, identity, and fact
follows from this.

A derivative is simply a measure of the rate of change. It can be the rate of change of distance
with respect to time or the temperature with respect to distance. We want to measure the rate
of change of a function with respect to its variable .

The general notion of rate of change of a quantity with respect to is the change in
divided by the change in about the point . This describes the average rate of
change and can be expressed as

To find the instantaneous rate of change, we take the limiting value as approaches
. To simplify this, we set , and we want to take the limiting value as
approaches 0. Thus, we have

If this limit exists and is finite, then we say that

Example:
Evaluate the derivative of 𝑥 2 at 𝑥 = 1using first principle.
Here 𝑓(𝑥) = 𝑥 2 and𝑐 = 1 . Using first principle, we can write